By James Hamilton, J.D., LL.M., Principal Analyst, CCH Federal Securities Law Reporter; and CCH Derivatives Regulation Law Reporter.
A House-Senate conference committee has reported out the Dodd-Frank Act providing for a sweeping overhaul of the regulation of US financial services and markets. The overhaul of the US financial regulatory system is based on the themes of regulating systemic risk, enhancing transparency and disclosure, a shareholder advisory vote on executive compensation from excessive risk, expanding consumer and investor protection, and preventing regulatory arbitrage. The legislation provides for the regulation of hedge funds, and OTC derivatives, as well as a new resolution authority to unwind failing financial firms. The legislation ends taxpayer bailouts of financial institutions and securities firms by creating a way to liquidate failed firms without taxpayer money.
The legislation would provide for joint SEC-CFTC regulation of derivatives, strengthen the SEC’s powers to better protect investors, and efficiently and effectively regulate the securities markets The Act would also reform the credit rating agency process by, among other things, mandating new rules for internal controls, independence, transparency and penalties for poor performance in order to restore investor confidence in these ratings. The legislation also establishes a systemic risk regulator based on the council of systemic risk regulators model employed in the European Union.
Systemic Risk Regulator
The financial crisis demonstrated that large, interconnected financial firms that pose a systemic risk to the entire financial system need to be under a consistent and conservative regulatory regime. These standards cannot simply address the soundness of individual institutions, but must also ensure the stability of the system itself.
Any financial institution that is big enough, interconnected enough, or risky enough that its distress necessitates government intervention is an institution that necessitates oversight by a federal agency responsible for managing the overall risk to the financial system. In a world where financial innovation is pervasive and where market conditions constantly change, regulators must be authorized to take a holistic view of the playing field, identifying gaps, pointing to unsustainable trends, and raising questions about new kinds of interactions.
Thus, the legislation would enact an early warning system by creating a regulator to police all systemically important firms and markets as a broad consensus develops on the need for Congress to create a systemic risk regulator. This regulator would be authorized to take proactive steps to prevent or minimize systemic risk. The legislation seeks to guarantee holistic regulation of the financial system as a whole, not just its individual components.
The legislation would create an independent agency with a board of regulators to identify and address systemic risks posed by large, complex companies, products, and activities before they threaten the stability of the financial system. The new Financial Stability Oversight Council, chaired by the Treasury Secretary and comprised of key regulators such as the Fed, SEC and CFTC, would monitor emerging risks to U.S. financial stability, recommend heightened prudential standards for large, interconnected financial companies, and require nonbank financial companies such as hedge funds to be supervised by the Federal Reserve if their failure would pose a risk to U.S. financial stability.
Office of Financial Research
The legislation establishes an executive agency to collect and standardize data on financial firms and their activities to aid and support the work of the federal financial regulators. The Office of Financial Research, headed by a Director appointed by the President for a six-year term, would provide the Council and financial regulators with the data and analytic tools needed to prevent and contain future financial crises by developing tools for measuring and monitoring systemic risk. The logic behind the Office is that it makes no sense to pass legislation creating a systemic risk regulator when there are no standardized tools for measuring systemic risk. The Office is patterned on an executive agency envisioned by the National Institute of Finance Act of 2010, , sponsored by Senator Jack Reed, Chair of the Securities Subcommittee.
The Office would not only develop the metrics and tools financial regulators need to monitor systemic risk, it would also help policymakers by conducting studies and providing advice on the impact of government policies on systemic risk. Thus, the Office would be required to provide independent periodic reports to Congress on the state of the financial system. This will ensure that Congress is kept apprised of the overall picture of the financial markets. The legislation provides for the Office to house a data center that would collect, validate and maintain key data to perform its mission.
Regulation of Derivatives
The financial crisis revealed that massive risks in derivatives markets went undetected by both regulators and market participants. In 2000, the Commodity Futures Modernization Act (CFMA) explicitly exempted OTC derivatives, to a large extent, from regulation by the CFTC. Similarly, the CFMA limited the SEC's authority to regulate certain types of OTC derivatives. As a result, the market for OTC derivatives has largely gone unregulated.
According to the Obama Administration, the downside of this lax regulatory regime became disastrously clear during the recent financial crisis when many institutions and investors had substantial positions in credit default swaps tied to asset backed securities. Excessive risk taking by AIG and certain monoline insurance companies that provided protection against declines in the value of such asset backed securities, as well as poor counterparty credit risk management by many banks, saddled the financial system with an enormous unrecognized level of risk. The sheer volume of these contracts overwhelmed some firms that had promised to provide payment on the credit default swaps and left institutions with losses that they believed they had been protected against. Lacking authority to regulate the OTC derivatives market, regulators were unable to identify or mitigate the enormous systemic threat that had developed. Financial Regulatory Reform: A New Foundation, June 2009
While OTC derivatives are supposed to protect businesses from risks, they became a way for companies to make enormous bets with no regulatory oversight and therefore exacerbated risks. Because the derivatives market was considered too big and too interconnected to fail, taxpayers had to foot the bill for bad bets that linked thousands of traders and created a web in which one default threatened to produce a chain of corporate and economic failures worldwide. These interconnected trades, coupled with the lack of transparency about who held what, made unwinding the “too big to fail” institutions more costly to taxpayers.
During last year’s financial crisis, concerns about the ability of companies to make good on these derivatives contracts, and the lack of transparency about what risks existed, caused credit markets to freeze. Investors were afraid to trade as Bear Stearns, AIG, and Lehman Brothers failed because any new transaction could expose them to more risk
In an effort to address the systemic risk to the financial markets posed by derivatives, the Senate legislation would mandate, for the first time, the federal regulation of derivatives under a dual SEC-CFTC regime that emphasize transparency. The CFTC would regulate swaps and the SEC would regulate security-based swaps.
The legislation includes mandatory clearing and trading requirements and real-time reporting of derivatives trades. Commercial end users using derivatives to hedge risk are exempted from mandatory swap clearing.
Corporate Governance
The Obama Administration and the G-20 have determined that corporate governance failures, including compensation that encouraged short-term risk taking, were significant causes of the financial crisis. Bonuses that rewarded short term profits over the long term health and security of the firm, and other incentive-based compensation for executives to take big risks with excess leverage, threatened the stability of their companies and the economy as a whole. Thus, the legislation gives shareholders a say on pay and proxy access, ensures the independence of compensation committees, and requires companies to set clawback policies to take back executive compensation based on inaccurate financial statements as important steps in reining in excessive executive pay and helping shift management’s focus from short-term profits to long-term growth and stability.
Say on Pay
The legislation would enhance corporate governance and mandate increased transparency of executive compensation. Shareholders would be given the right to a non-binding vote on executive compensation. The advisory vote on executive compensation is designed to give shareholders a powerful opportunity to hold accountable executives of the companies they own, and a chance to disapprove where they see the kind of misguided incentive schemes that threatened individual companies and, in turn, the broader economy..
The shareholder advisory vote on executive pay will not overrule a decision by the company or the board, or create or imply any change to, or addition to, the fiduciary duties of the directors, or restrict the ability of shareholders to make inclusion in proxy materials related to executive compensation.
Dual Roles
It is widely acknowledged that a sound corporate governance practice is to bifurcate the roles of board chairman and CEO. Thus, the SEC is directed to adopt rules requiring a company to disclose in the annual proxy sent to investors the reasons why it has chosen the same person to serve as chairman of the board of directors and chief executive officer or why it has chosen different individuals to serve as board chair and chief executive officer. Section 973
Compensation Committees
In a major corporate governance improvement, the legislation mandates independent board compensation committees. The SEC must adopt rules for exchange listing requiring that compensation committees include only independent directors and have authority to hire compensation consultants. This provision is designed to strengthen their independence from the executives they are rewarding or punishing.
Hedging
The SEC is also directed to adopt rules requiring a company to disclose whether any employee or director is permitted to purchase financial instruments, including derivatives such as equity swaps, that are designed to hedge or offset any decrease in the market value of equity securities granted to the employee or director by the company as part of the compensation of the employee or directors or held directly or indirectly by the employee or director.
Executive Compensation Disclosure
The SEC is required to amend Item 402 of Regulation S-K to mandate disclosure of the median of the annual total compensation of all employees, except the CEO; the annual total compensation of the CEO; and the ratio of the two. The annual total compensation of an employee must be determined by reference to Item 402 of Regulation S-K. This disclosure is required in annual reports and proxy statements, among other filings.
Voting by Brokers
In addition, exchange rules must prohibit members that are not beneficial owners of a security from granting a proxy to vote the security in connection with a shareholder vote for the election of directors, executive compensation, or any other significant matter as the SEC may determine by rule, unless the beneficial owner of the security has instructed the member to vote the proxy in accordance with the voting instructions of the beneficial own.
Hedge Fund and Private Equity Fund Advisers
The legislation would require SEC registration of hedge fund advisers and disclosure of information to the Commission under a confidentiality regime. The SEC must require hedge fund advisers to disclose the amount of assets under management, their use of leverage and counterparty credit risk exposure, as well as their trading and investment positions, their valuation methodologies, and any side arrangements or side letters that treat fund investors more favorably than other investors.
The legislation brings hedge fund advisers under SEC regulation by eliminating the exemption in section 203(b)(3) of the Investment Advisers Act for advisers with fewer than 15 clients. Under current law, a hedge fund is counted as a single client, allowing hedge fund advisers to escape the obligation to register with the SEC. The legislation exempts foreign private advisers, as well as containing a limited intrastate exemption, and an exemption for small business investment companies licensed by the Small Business Administration. There is an exemption for venture capital fund advisers.
Family Offices
Family offices provide investment advice in the course of managing the investments and financial affairs of one or more generations of a single family. Since the enactment of the Investment Advisers Act, the SEC has issued orders to family offices declaring that those family offices are not investment advisers within the intent of the Act and thus not subject to registration. The legislation essentially codifies the SEC position by excluding family offices from the definition of investment adviser under Section 202(a)(11) of the Advisers Act.
The legislation raises the asset threshold above which investment advisers must register with the SEC from the $25,000,000 set in 1996 by the National Securities Markets Improvement Act to $100,000,000.
Accredited Investors
Accredited investor status, defined in SEC regulations, is required to invest in hedge funds and other private securities offerings. Accredited investors are presumed to be sophisticated, and not in need of the investor protections afforded by the registration and disclosure requirements of the federal securities laws. For individuals, the accredited investor thresholds are dollar amounts for annual income ($200,000 or $300,000 for an individual and spouse) and net worth of $1 million, including the value of a person‘s primary residence). These amounts have not been adjusted since 1982. Thus, legislation irects the SEC to adjust the net worth needed to attain accredited investor status to $1,000,000, excluding the value of the person’s primary residence. Within the period of four years after enactment, however, the net worth standard must be $1,000,000, excluding the value of the primary residence.
The legislation also directs the SEC, four years after enactment, and once every 4 years thereafter, to review the definition of accredited investor to determine whether the requirements of the definition should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy. Upon completion of the review, the SEC may adjust the term accredited investor.
Clearing and Settlement
In order to mitigate systemic risk in the financial system and promote financial stability, the legislation
SEC Collateral Bars
Currently, a securities professional barred from being an investment adviser for serious misconduct could still participate in the industry as a broker-dealer. Noting that improved sanctions would better enable the SEC to enforce the federal securities laws, the Obama Administration sought authority for the SEC to impose collateral bars against regulated persons across all aspects of the industry rather than in a specific segment of the industry. The interrelationship among the securities activities under the SEC’s jurisdiction, the similar grounds for exclusion from each, and the SEC’s overarching responsibility to regulate these activities support the imposition of collateral bars.
Thus, the legislation authorizes the SEC to impose collateral bars against regulated persons. The Commission would have the authority to bar a regulated person who violates the securities laws in one part of the industry, such as a broker-dealer who misappropriates customer funds, from access to customer funds in another part of the securities industry, for example, an investment adviser. By expressly empowering the SEC to impose broad prophylactic relief in one action in the first instance, this provision would enable the SEC to more effectively protect investors and the markets while more efficiently using SEC resources.
SEC Fair Fund
The Fair Fund provisions of the Sarbanes-Oxley Act take the civil penalties levied by the SEC as a result of an enforcement action and direct them to a disgorgement fund for harmed investors. The legislation would increase the money available to compensate defrauded investors by revising the Fair Fund provisions to permit the SEC to use penalties to recompense victims of the fraud even if the SEC does not obtain an order requiring the defendant to disgorge ill-gotten gains. Currently, in some cases, a defendant may engage in a securities law violation that harms investors, but the SEC cannot obtain disgorgement from the defendant because the defendant did not personally benefit from the violation.
PCAOB
The Madoff fraud revealed that the Public Company Accounting Oversight Board lacked the powers it needed to examine the auditors of broker-dealers. Thus, the legislation brings broker-dealers under the PCAOB oversight regime. The PCAOB is given authority over audits of registered brokers and dealers that is generally comparable to its existing authority over audits of issuers. This authority permits the Board to write standards for, inspect, investigate, and bring disciplinary actions arising out of, any audit of a registered broker or dealer. It enables the PCAOB to use its inspection and disciplinary processes to identify auditors that lack expertise or fail to exercise care in broker and dealer audits, identify and address deficiencies in their practices, and, where appropriate, suspend or bar them from conducting such audits.
Investor Protection for Seniors/Financial Literacy/Underserved Investors
The three vital components of financial literacy are education, consumer protection, and economic empowerment, and the legislation includes essential provisions in all three of these areas for consumers and investors. See remarks of Sen. Daniel Akaka, Cong. Record, Apr 30, 2010, p. S2996. With regard to education, the legislation requires a the SEC to conduct a financial literacy study and develop an investor financial literacy strategy intended to bring about positive behavioral change among investors. Section 916. In addition, an Office of Financial Literacy is created within the new Consumer Financial Protection Bureau and is tasked with implementing initiatives to educate and empower consumers. Section 1013. A strategy to improve the financial literacy among consumers, that includes measurable goals and benchmarks, must be developed.
With regard to the second key component of financial literacy, consumer protection, the Act strengthens the ability of the SEC to better represent the interests of retail investors by creating an Investor Advocate within the SEC. Section 911. The Investor Advocate is tasked with assisting retail investors to resolve significant problems with the SEC or the self-regulatory organizations. The Investor Advocate’s mission includes identifying areas where investors would benefit from changes in Commission or SRO policies and problems that investors have with financial service providers and investment products. The Investor Advocate will recommend policy changes to the Commission and Congress in the interests of investors.
The legislation also authorizes the SEC to effectively require disclosures to retail investors prior to the sale of financial products and services. Section 918. This provision will ensure that investors have the relevant and useful information they need when making decisions that determine their future financial condition. The information to be disclosed by SEC rule must be in summary format and contain concise information about investment objectives, strategies, costs, and risks, as well as any compensation or financial incentive received by the financial intermediary in connection with the purchase of the retail investment product.
The measure authorizes the SEC to gather information from and communicate with investors and engage in such temporary programs as the Commission determines are in the public interest for the purpose of evaluating any rule or program of the SEC. Section 912. In the past, the SEC has carried out consumer testing programs, but there have been questions of the legality of this practice. This legislation gives clear authority to the SEC for these activities.
The legislation modifies the Electronic Fund Transfer Act to establish remittance consumer protections. It would require simple disclosures about the costs of sending remittances to be provided to the consumer prior to and after the transaction. A complaint and error resolution process for remittance transactions would also be established. Section 1076.
On the third component, economic empowerment, the legislation intends to increase access to mainstream financial institutions for the unbanked and the underbanked. The legislation authorizes programs intended to assist low- and moderate-income individuals establish bank or credit union accounts and encourage greater use of mainstream financial services. Title XII would also encourage the development of small, affordable loans as an alternative to more costly payday loans.
Credit Rating Agencies
Credit rating agencies market themselves as providers of independent research and in-depth credit analysis. But in the financial crisis, instead of helping people better understand risk, they failed to warn people about risks hidden throughout layers of complex securitized structures.
Flawed methodology, weak oversight by regulators, conflicts of interest, and a total lack of transparency contributed to a system in which AAA ratings were awarded to complex, unsafe asset-backed securities and other derivatives, adding to the housing bubble and magnifying the financial shock caused when the bubble burst. When investors no longer trusted these ratings during the credit crunch, they pulled back from lending money to municipalities and other borrowers.
The legislation establishes an independent office within the SEC dedicated to improving the quality of regulation of credit rating agencies. The Office of Credit Ratings, headed by a direct report to the SEC Chair, will promote accuracy in credit ratings and keep conflicts of interest from unduly influencing ratings.
The Office of Credit Ratings must also conduct annual examinations of each credit rating agency, including a review of its policies, procedures, and rating methodologies and whether it follows these policies, the management of conflicts of interest, the implementation of ethics policies; the internal supervisory controls of the agency, the governance of the agency; the activities of its compliance officer; the processing of complaints, and the policies of the agency governing the post-employment activities of former staff.
Reform of Securitization
In many ways, the financial crisis was at root a crisis of securitization. While traditional securitization was a successful tool for bundling loans into asset-backed securities, in the last decade it morphed into the short-term financing of complex illiquid securities whose value had to be determined by theoretical models. The inherent fragility of this new securitization model was masked by the actions of market intermediaries, particularly credit rating agencies. Predatory mortgages and securitization of those mortgages on Wall Street built a house-of-cards economy. The predatory subprime mortgages were done at the retail level, but the securitization and selling of those packages occurred on Wall
Street. Remarks of Senator Jeff Merkley, Cong. Record May 6, 2010, S3319.
The collapse of structured securitization revealed the ugly reality that, far from managing and dispersing risk, it had increased leverage and concentrated risk in the hands of specific financial institutions. The Obama Administration proposed the reform securitization by changing the incentive structure of market participants; increasing transparency to allow for better due diligence; strengthening credit rating agency performance; and reducing the incentives for over-reliance on credit ratings. Provisions of the draft legislation would implement these goals.
One of the most significant problems in the securitization markets was the lack of sufficient incentives for lenders and securitizers to consider the performance of the underlying loans after asset-backed securities were issued. Lenders and securitizers had weak incentives to conduct due diligence regarding the quality of the underlying assets being securitized. This problem was exacerbated as the structure of those securities became more complex and opaque. Inadequate disclosure regimes also exacerbated the gap in incentives between lenders, securitizers and investors.
There is a growing consensus that we have ``crossed the Rubicon’’ into originate and distribute securitization and there is no turning back to originate and hold. Indeed, restarting private-label securitization markets, especially in the United States, is critical to limiting the fallout from the credit crisis and to the withdrawal of central bank and government interventions. However, no one wants policies that would take markets back to their high octane levels of 2005–07. Thus, the legislation aims to put securitization on a solid and sustainable footing.
The legislation reforms the process of securitization by, primarily, requiring companies that sell products like mortgage-backed securities to retain a portion of the risk to ensure that they will not sell toxic securities to investors, because they have to keep some of it for themselves. The legislation would require companies that sell products like mortgage-backed securities to keep some ``skin in the game’’ by retaining at least five percent of the credit risk so that, if the investment doesn’t pan out, the company that made, packaged and sold the investment would lose out right along with the people they sold it In addition, the legislation would require issuers to disclose more information about the assets underlying asset-backed securities and to analyze the quality of the underlying assets.
Specifically, the legislation directs regulations to require any securitizer to retain a material portion of the credit risk of any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells, or conveys to a third party. When securitizers retain a material amount of risk, they have skin in the game, thereby aligning their economic interests with those of investors in asset-backed securities. Securitizers who retain risk have a strong incentive to monitor the quality of the assets they purchase from originators, package into securities, and sell.
Resolution Authority
According to Treasury, the lack of a federal regulatory regime and resolution authority for large systemic financial institutions contributed to the financial crisis and, unless addressed with legislation, will constrain a federal response to future crises. As demonstrated by AIG, severe distress at large global non-depository financial institutions can pose systemic risks to the financial markets just as distress at banks can.
Title II establishes an orderly liquidation authority to unwind large complex systemically important financial firms whose failure could put the entire financial system in jeopardy. According to Senator Mark Warner, a co-author of Title II, said that the title embodies three key principles: 1) it ends too big to fail; 2) the regime would be rarely used with bankruptcy remaining the preferred method; and 3) taxpayers are not burdened Senator Dodd said that the liquidation authority will wind down failing financial firms, force shareholders to be wiped out and culpable management to be fired, force creditors to bear loss and claw back any payment to creditors above liquidation value. The regime is designed to keep out non-financial commercial firms with a definition of financial company in which 85 percent of the revenues come from financial activities. This definition was intentionally designed to exclude commercial firms. The FDIC must run each receivership separately with separate accounting. House-Senate Conference Committee Meeting, June 17, 2010.
Thus, the legislation establishes an orderly liquidation authority to give the U.S. government a viable alternative to the undesirable choice it faced during the financial crisis between bankruptcy of a large, complex financial company that would disrupt markets and damage the economy, and bailout of such financial company that would expose taxpayers to losses and undermine market discipline. The new orderly liquidation authority would allow the FDIC to safely unwind a failing nonbank financial firms or bank holding companies, an option that was not available during the financial crisis. The process includes several steps intended to make the use of this authority very rare. There is a strong presumption that the Bankruptcy Code will continue to apply to most failing financial companies..
Once a failing financial company is placed under this authority, liquidation is the only option; since the failing financial company may not be kept open or rehabilitated. The financial company‘s business operations and assets will be sold off or liquidated, the culpable management of the company will be discharged, shareholders will have their investments wiped out, and unsecured creditors and counterparties will bear losses.
The Dodd-Shelby Amendment, in conjunction with the Boxer Amendment, ends the idea that any firm can be too big to fail. Pursuant to the Dodd-Shelby Amendment, the legislation creates an orderly liquidation mechanism for the FDIC to unwind failing systemically significant financial companies. This mechanism represents a fundamental change in federal law that will protect taxpayers from the economic fallout of the collapse of a large interconnected systemically significant financial firm. Senator Chris Dodd, Cong Record, May 5, 2010, S3131.
Shareholders and unsecured creditors will still bear losses and management at the failed firm will be removed. In fact, the Dodd-Shelby Amendment empowers regulators to bar culpable management and directors of failed firms form working in the financial sector. According to Senator Dodd, it makes sense that if someone has been involved in the mismanagement of a company and caused such disruption in the economy they should be banned from engaging in further economic activities. Senator Chris Dodd, Cong Record, May 5, 2010, S3131.
Subject to due process protections, regulators can ban from the financial industry senior executives and directors at failed financial firms upon determining that they violated a law or regulation, a cease and desist order, or an agreement with a federal financial regulator; or breached their fiduciary duty; or engaged in an unsafe or unsound practices. In addition, the executive must have benefitted from the violation or breach, which must also involve personal dishonesty or a willful or continuing disregard for the firm’s safety or soundness. The length of the industry ban is in the regulator’s discretion, but must be at least two years.
The Dodd-Shelby Amendment also requires post-resolution reviews to determine if regulators did all they were supposed to do to prevent the failure of a systemically significant institution. According to Senator Shelby, this post-resolution review is essential to hold regulators accountable for their actions or inactions as the case may be. Cong. Record, May 5, 2010, S3140.
The Boxer Amendment puts to rest any doubt that the legislation ends federal bailouts of financial firms. The amendment means that no financial company is going to be kept alive with taxpayer money. Remarks of Senator Boxer, Cong. Record, May 4, 2010, S3063.
Payment, Clearance and Settlement
Title VIII requires tough and heightened regulation of systemically important financial market utilities. There is presently no safety valve if they cannot perform their functions. The title would reduce systemic risk and complement existing SEC and CFTC regulation. It is a safeguard for financial market utilities that run into extraordinary liquidity problems. Plus, financial market utilities should not be carved out of systemic risk oversight. Financial market utilities provide critical services to the financial system, such as the clearing and settlement of US government securities, municipal securities, and derivatives.
According to Senator Shelby, the legislation provides for enormous new duties for central clearinghouses. Derivatives legislation will mandate the clearing of many OTC derivatives for the first time. In this regard, he said that it is not possible to have an effective derivatives title without an effective payment, clearance and settlement title. Risk oversight role for Fed and discount window access for clearinghouses in a liquidity crunch will be important to ensure the stability of the financial system,
Fixed Index Annuities
The Harkin Amendment was inserted into the legislation that would treat fixed index annuities as insurance products to be regulated by state insurance officials, thereby essentially nullifying SEC Rule 151A. The amendment was offered by Senator Tom Harkin. Senator Jack Reed opposed the Harkin Amendment, stating that the SEC would be a more effective regulator of these hybrid instruments.
A fixed index annuity is a hybrid financial product that combines some of the benefits of fixed annuities with the added earning potential of a security. Like traditional fixed annuities, fixed index annuities are subject to state insurance laws, under which insurance companies must guarantee the same 87.5 percent of purchase payments. Unlike traditional fixed annuities, however, the purchaser’s rate of return is not based upon a guaranteed interest rate.
Rule 151A defines indexed annuities as not being exempt annuity contracts under Section 3(a)(8) of the Securities Act. Relying on a series of US Supreme Court rulings, the SEC reasoned that, given the unpredictability of the securities markets, index annuities contain substantial risk that must be addressed by the disclosure regime established by the Securities Act. Last year, a panel of the US Court of Appeals for the District of Columbia ruled that the rulemaking process was flawed by the fact that the SEC’s consideration of the effect of Rule 151A on efficiency, competition, and capital formation, as required by Securities Act Section 2(b), was arbitrary and capricious. American Equity Investment Life Insurance Co. v. SEC, No. 09-1021, CA DofC Circuit.
The Harkin Amendment mirrors bi-partisan legislation introduced earlier in the Senate that would nullify the Commission’s adoption of Rule 151A before it has a chance to take effect. The Harkin provision provides that Rule 151A will have no force or effect. The draft legislation expresses a congressional sense that the SEC’s adoption of Rule 151A interferes with state insurance regulation, harms the insurance industry, reduces competition, and creates unnecessary and excessive regulatory burdens. The measure also embodies a congressional finding that indexed insurance and annuity products offered by insurance companies are subject to a wide array of state laws and regulations, including non-forfeiture requirements that provide for minimum guaranteed values, thereby protecting consumers against market swings.
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